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The Automatic 401(k) vs. the IRA

Do you know the difference, and are you invested the right way?

As tough as times have been for workers trying to save for retirement, there's at least one piece of good news. Increasingly, employers are automatically signing up their employees to participate in company-sponsored retirement accounts such as 401(k) plans.

It might seem insulting that your employer would sign you up for a 401(k) instead of asking you to do it yourself. But the sad truth is that when it's up to us to take action, many of us don't -- and our futures will suffer for it. So if you ask me, I say hooray for automatic enrollment!

Proving my point, The Washington Post reported last year that "[a]bout one-third of eligible workers do not participate in their employers' 401(k)-type plans, according to the Labor Department. Studies have shown that automatic enrollment could reduce that rate to less than 10%."

Targeted fundsYou may reasonably ask at this point just how an employer might invest this money of yours that's being diverted into a 401(k) account. Well, it can choose from customized portfolios and funds that balance stocks and bonds. A popular option is likely to be "target-date" or "life-cycle" funds.

A target-date mutual fund is designed around a specific retirement date, with its investments chosen accordingly. The Vanguard 2025 (VTTVX) fund, for example, is for those who plan to retire in 2025. It recently had 77% of its assets in stocks and 23% in bonds and cash (along with a 3.5% dividend yield); its Vanguard 2045 (VTIVX) counterpart had 89% in stocks and 11% in bonds and cash (and a 3.2% yield). Each fund shifts your assets as you get older, adding more bonds in later years.

Target-date funds tend to invest in a handful of other funds from the family's lineup. The Vanguard 2025 fund, for example, recently had 62% of its assets in Vanguard's Total Stock fund, 8% in its European Stock fund, and 3% in its Emerging Markets fund. That gives you exposure to lots of different types of companies:

Fund

5-Year Annualized Return

Holdings Include

Total Stock (VTSMX)

(37%)

Procter & Gamble(NYSE:PG),

Chevron(NYSE:CVX),

AT&T(NYSE:T)

European Stock (VEURX)

(44.7%)

BP(NYSE:BP),

Novartis(NYSE:NVS)

Emerging Markets (VEIEX)

(52.8%)

Petrobras(NYSE:PBR),

America Movil(NYSE:AMX)

Source: Morningstar.

Of course, over the past year, you might have wished your employer would just leave your money in a cash fund. But while "safe" options do better in bear markets, they aren't likely to help workers build substantial (and necessary) nest eggs over time.

IRA mattersSo, should you invest all your available dollars in your 401(k), or should you invest in an IRA? There's no single best answer for everyone, I'm afraid. For many people, the best choice might be to use both.

One factor to consider is what you expect your future income tax rate to be. By using a 401(k) or traditional IRA, you get your taxes deferred on your contributions, and you'll pay them in retirement. If your rate is lower then (probably due to a lower income level), it makes sense to invest significantly in these vehicles.

If your rate is lower now than you expect it to be later, a Roth IRA can be extra attractive, as it has you pay your taxes upfront, then you enjoy tax-free withdrawals in retirement. (Learn much more about IRAs here.)

Of course, how on earth can we know what our incomes will be in 10, 20, or 30 years, much less what the prevailing income tax rates will be? That's why it is smart to hedge your bets a little. (Note: One detail that can sway your decision is whether your company offers to match any of your 401(k) contributions to some degree. If it does, it's usually smart to grab as many of those matching dollars as you can: They are free money.)

Prepare for your golden yearsI encourage you to take advantage of a free trial of our Rule Your Retirement newsletter service. It's prepared by Robert Brokamp, a smart and witty guy who distills all of what you need to know into a manageable volume each month.

A free trial will give you full access to all past issues, allowing you to gather valuable tips and even read how some folks have retired early and well. Robert regularly offers recommendations of promising stocks and mutual funds, too.

Author

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter... Follow @SelenaMaranjian